Impact of ESG Aspects on M&A Activities

The role of ESG is increasingly valued as the market adapts to a constantly changing world. The critical driver is investors’ willingness. Around the world, particularly in the European Union, companies are facing increasingly stringent environmental rules and regulations. As a result, investors are also more willing to invest in companies that are more attentive to strict environmental regulations and thus have higher ESG indicators.

ESG is also relevant in the field of real estate. The underlying environmental standards and the increasing importance of ESG have led to a steady increase in the value of real estate. Aging, outdated and therefore energy-inefficient buildings require continuous renovation, which also increases investments in construction.

If a company is not attentive to ESG-factors, then it is a less desirable investment for conscious investors, which can damage its reputation. ESG-conscious companies, therefore, seek to avoid regulatory conflicts and mitigate reputational risks. The benefits of a proactive ESG strategy considered by companies include participation in tax policy debates, brand building, tax incentives, reduced tax risk, and reduced insurance premiums.

Besides environmental protection, the other important factor is the social factor meaning the well-being of the employees. Not only have environmental rules tightened, but rules towards worker protection as well. Employers are expected to ensure a safe and healthy working environment. Obligations of the ESG’s social factor related to social protection, e.g., carrying out a prior risk assessment, choosing competent and qualified workers, having informing responsibilities.

Role in M&A Deals

Due to the rising importance of ESG factors, ESG will continue to be an increasing concern in transactional due diligence. Before ESG became a trend, transactional due diligence primarily focused on the target’s historical financial and legal background. Certain key ESG factors were already part of traditional due diligence, like climate change and environmental issues, anti-bribery and corrupt business practices, diversity and labor issues, and data privacy.

Due diligence for ESG issues demands a broader analysis of the potential risks for the target company, taking into account various factors like the jurisdiction, sector and business. The purpose of the ESG-related due diligence is to disclose the target company’s risk profile and risk exposure.

If an ESG risk has been identified within the due diligence, the investor may consider requesting contractual protection in the acquisition agreement. A standard warranty package, which includes representations and warranties on legal and regulatory compliance, environmental and employee matters, should offer significant protection. With the growing focus on ESG, investors may consider negotiating additional ESG-related representations and warranties, like compliance with applicable ESG policies, labor law and environmental law warranties, etc.

When contemplating an acquisition, the investors will also investigate how the target company fits into the investors’ company group. Within the framework of sustainable investing, an analysis and an action plan should be prepared on how ESG considerations can be mainstreamed into the target company’s operations.

It is important for investors to minimize the risks of their investments, which is possible through conscious investment thanks to a more extensive investor base. A higher ESG score implies predictability, so companies are better prepared for external shocks and market changes. Investors take ESG indicators into account and incorporate them into their strategies and basic due diligence processes, thus increasing their impact.

This article was first published in the Budapest Business Journal print issue of December 17, 2021.